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Robert Pozen, senior lecturer at Harvard Business School, has said limiting tax deductions for the interest corporations pay on their bonds and debt issuances could help fund US tax reform. However, taxpayers have identified a number of problems with the idea.

In Pozen’s FT opinion
piece, earlier this month, he argued that limiting
corporate interest deductibility "could raise the required
revenue for a 10-percentage point reduction in the corporate
tax rate".

"And this change would also improve the allocation of
capital and deter excessive leverage," added Pozen, who said
the main options for funding a corporate tax
rate reduction – broadening the tax base (for instance
to include partnerships and limited liability companies),
ending deferral, or eliminating tax expenditures – are
insufficient to fund a substantial rate cut, and are not
"politically feasible".

But Jeff Bergmann, vice president, tax and treasury at
computer storage and data management company, NetApp, told
International Tax Review that a move to limit the
deductions available to corporations for the interest they pay
on bonds and other debt they issue would raise various
concerns.

"It does not seem fair to me that they would change the
rules on deductibility when companies made decisions on issuing
debt based upon the overall impact (after tax cost). Some debt
cannot be called or prepaid without substantial penalties,"
said Bergmann. "Also, I’m not sure what the impact
would be on investors – especially retired individuals
that count on fixed income investments as there would be less
paper out in the market to invest in – and on the
financial industry."

Richard Booker, corporate tax director at petroleum and
petrochemical company Sunoco, said that while it is a novel
concept, limiting the corporate interest deduction would not be
an optimal trade-off for a reduction in the corporate tax rate. If it
were to happen, though, he would like to see suitable
transitional arrangements put in place.

"Assuming tax revenue neutrality, there are bound to be some
winners and losers with this proposal. You could imagine some
corporations that are currently highly leveraged may end up
paying more in tax from the proposed change – should
the value of the deduction exceed the benefit of the rate
reduction – while others may end up with a lower
federal tax bill," said Booker. "Those companies availing
themselves extensively of the deduction under current law
should be provided a grace or phase-in period to adjust to the
change at the very least."

Despite these reservations, some taxpayers have reacted more
positively to Pozen’s suggestion. Jim Ditkoff, senior vice president,
finance and tax, at science and technology company Danaher
Corporation, said limiting the corporate interest deduction
"makes a lot of sense from both a revenue and a policy
perspective" but added there are two ways to do this.

"The deferral approach would limit the interest deduction in
any given year to a reasonable percentage of taxable income,
such as 30% of EBITDA, with an unlimited carryover of any
excess interest expense. The permanent approach would simply
disallow a fixed percentage of otherwise deductible interest
expense. That’s OK, too, if it’s
prospective," said Ditkoff.

However, Ditkoff agrees with Bergmann that companies that
have made decisions based on existing deductibility rules
should not be adversely hit by a change in the law.

"The deduction for interest on pre-enactment long-term debt
should not be subject to any sort of permanent disallowance
unless the debt is substantially modified within the meaning of
1.1001-3," he said. "It is one thing to reduce the tax
incentives for future debt financing. But it is not right to
punish companies for financing decisions made in the past in
good faith reliance on existing law. Also, it goes without
saying that any interest deduction limitations should apply to
net interest expense. Nobody, with the possible exception of
the Swedish tax authorities, thinks
it’s OK to tax all of a taxpayer’s
interest income while disallowing a portion of that same
taxpayer’s deduction for interest expense."

Booker identifies wider-ranging reasons for opposing the
move to limit corporate interest deductibility, arguing it
would harm the US economy and instead suggesting the removal of
personal income tax on dividends.

"Certain financial markets and industries could be damaged
by this proposal, and a contraction in the debt markets and
support industries could be detrimental to the US economy. I do
not see excessive leverage as a material concern in corporate
America – many corporate entities are currently flush
with cash stemming from real or perceived economic
uncertainties," said Booker. "Consequently, I would reject the
assertion that the proposed change is beneficial from that
standpoint. Further, the elimination of personal income tax on
dividends would likely be more beneficial in the efficient
allocation of capital than this proposal."

Rate reduction

Generally speaking, taxpayers and policymakers are in agreement that the US corporate tax
rate should be lowered.

"Now that we have prevented a Democrat tax increase, the
House Ways & Means Committee will lead the effort to reform our tax code to make it
simpler and fairer," said Dave Camp, Ways & Means Committee
chairman (pictured left), "while also making American
businesses and workers more competitive in the global
marketplace."

Pozen claims his proposal would enable a
lowering of the 35% corporate tax rate "to a more reasonable
25%".

Booker advocates attempts to get the 35% rate down, agreeing
that a rate reduction would increase economic growth.

"In general, a lower rate would provide much better optics
for the US. Rates are generally the most important tax
consideration to many corporate executives, and the reduction
in rate could spur growth in industry and commerce in the US
that may outweigh the negative aspects of the proposal on
discrete taxpayers," he said.

Retroactive measures

One issue Booker raises in the debate surrounding comprehensive reform of the US tax code is
the use of retroactive measures, saying this type of
measure – which applies to various credits and
incentives including industry-specific measures and certain
charitable and social provisions – is his "least
preferred corporate benefit".

"When Congress retroactively reinstates corporate
benefits, they incentivise no one as the company has
either made the commitment to spend the funds or has chosen not
to. Consequently, in those instances, taxpayers would generally
be better served by Congress not having to borrow money to
extend the benefit (when a federal surplus exists, this would
not hold)," he said. "In other instances, the companies that
receive most of the benefits are those larger entities that
have the resources to ensure they qualify for the benefits.
This causes distortions that I would argue tend to outweigh the
perceived benefits sought through the enactment of such
provisions. Consequently, a broader corporate tax base in this
respect would likely benefit the US tax structure."

The complexity of the tax code, and the plethora of tax
breaks and incentives contained therein, means the removal of
any provision would impact a certain section of taxpayers,
hence the level of lobbying surrounding provisions in the tax
code. Because of this, Booker recommends focusing on cutting
spending to bring down the deficit.

"Every existing provision in the corporate code is important
to some industry or group. Consequently, to best benefit the US
taxpayers and economy, a reduction in federal spending should
be Congress’s top priority in reducing its
deficit," said Booker.

But with the length of time needed to deal with the fiscal cliff, action on any
of the proposals above should not necessarily be expected soon,
particularly given Washington leadership’s recent track record, warned Jim Fuller of
Fenwick & West.